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08/29/2010

Is the Federal Government Broke? Posner

A company or other organization, or an individual, is insolvent when its liabilities (what it owes) exceed the market value of its assets. Bankruptcy is a legal mechanism for liquidating or reorganizing an insolvent entity in a way that maximizes value for the creditors. When a firm is insolvent, each of its creditors is eager to be repaid what he is owed, out of the firm’s assets. By definition those assets are insufficient to satisfy all the creditors’ claims, so the creditors race to obtain judgments, which are then satisfied by sale of the firm’s assets, perhaps at fire-sale prices because of the race. Even if the firm could be saved as a going concern by eliminating some of its debt burden (its liabilities), transaction costs will make it difficult for the creditors to agree on how far their respective claims will be written down—how in short to share the grief. In a bankruptcy proceeding, the creditors are barred from suit and the judge supervises an orderly disposition of assets (whether by liquidation or by placing them in a reorganized entity) designed to maximize their value and hence the creditors’ ultimate return.

Bankruptcy is not limited to individuals and business firms; under U.S. law, even a city can be declared bankrupt; and this happens occasionally. In one Illinois town, the bankruptcy judge ordered the sale of city hall to satisfy creditors’ claims. U.S. states cannot be subjected to bankruptcy proceedings, and neither can the federal government, or the governments of other nations. But that doesn’t mean that a state or nation can’t be insolvent. Insolvency is the condition; bankruptcy is a method of treating the condition.

A nation has creditors in both a narrow and a broad sense. In the case of our federal government, they are of four types: owners of federal securities (Treasury bonds and short-term bonds called Treasury bills or Treasury notes); other persons or firms that have contracts with the federal government, for example for sale of goods or services to it; holders of federal entitlements, such as social security, Medicare, Medicaid, and the pensions of retired federal employees; and beneficiaries of government services (as distinct from transfer payments), such as drivers on interstate highways and visitors to national parks, as well as the population at large, which is protected from crime and foreign aggression by federal police and military forces.

The first two categories of holders of government “debt” in a broad sense—owners of government bonds and holders of government contractors—correspond closely to the creditors of private companies. The third does not because federal entitlements can always be cut with impunity, from a legal standpoint; and the fourth are not entitlements, but services that are funded by annual congressional appropriations and so can be altered without being thought to disrupt settled expectations; they are the domain of “discretionary” government spending, though in a legal sense entitlements are discretionary also rather than being fixed and legally enforceable obligations.

But remember that insolvency is the condition, bankruptcy merely a treatment for the condition; and a condition is not less grave just because the best treatment for it is unavailable—in fact the condition is more serious in that case.

These reflections are suggested by the first issue (August 25) of a new publication by Morgan Stanley called Sovereign Subjects. The first issue is captioned “Ask Not Whether Governments Will Default, but How.” It is a criticism of the conventional method of evaluating a nation’s economic condition, which is to compare public debt (government bonds) to Gross Domestic Product. In the case of the United States, that ratio in percentage terms is 53 percent, which is high by historical standards but lower than that of a number of European nations, which are listed in the report (France, Germany, Greece, Ireland, Italy, Portugal, Spain, and the U.K.). But as the report points out, this is not a proper way to determine solvency. The proper way is to compare assets and liabilities. The major asset of any government is its taxing power, which of course cannot be equated to the entire GDP, or the entire value of the nation’s human and physical capital; for both economic and political reasons, the taxing power is limited to a percentage of GDP well below 100 percent. And, realistically, the liability side of the national ledger includes not only government bonds but also other contractual obligations, entitlements, and at least strongly anchored expectations concerning government services (we’re not about to eliminate our armed forces). In addition, as especially emphasized in the Morgan Stanley report, the national balance sheet must be reckoned in dynamic terms, with due regard for likely increases both in GDP and in liabilities, especially increases in entitlement spending that are likely to result from the continued ageing of the population.

Because American tax rates are low by international standards and resistance to increasing them is fierce, Morgan Stanley’s report estimates that the ratio of current U.S. public debt to realistically realizable tax revenues is 3.58 to 1, which is the highest by a large margin of the countries in the report’s list; only Greece comes close (3.12 to 1). But America has certain advantages, such as a younger population and a more rapid rate of economic growth, and as a result its ratio of net worth to GDP is in the middle of Morgan Stanley’s list of countries—but it is strongly negative, as are the ratios of all the countries in the list (Italy, surprisingly, being at the top, and Greece, unsurprisingly, at the bottom). According to Morgan Stanley’s calculation (which obviously is merely suggestive, as the report emphasizes, because of the uncertainty of the future), America’s net worth is negative, and this negative net worth is eight times larger than our GDP. This means that the net present value of the government’s liabilities, minus assets, is approximately $120 trillion.

What does a firm or an individual do when it is broke and there is no bankruptcy regime? It defaults. Nations do occasionally default on their bonds or other contractual obligations; or, if the bonds or other obligations are denominated in the local currency, they inflate the currency and so repay their obligations in cheaper money, which is the equivalent of a partial default. The U.S. government is unlikely to do either of these things and therefore, in conventional parlance, is not insolvent. But as the Morgan Stanley report insightfully emphasizes, the government has other “stakeholders,” and they are creditors in a loose but illuminating sense. A cut in social security, Medicare, or other entitlements amounts to breaking the government’s promises to the holders of these entitlements, promises on which the holders have relied. So does reducing government services (highways, police, etc.) or increasing taxes, which reduces the net value of those services.

The deeper the financial hole that the government has dug for itself by incompetent economic management—and our government has dug itself a very deep hole, largely because of the mismanagement of monetary policy and financial regulation by the Federal Reserve under Greenspan and Bernanke and by other government agencies—the more difficult it is to climb out of the hole on the backs of holders of entitlements and recipients of government services. The political resistance is too intense. It’s at that point that the bondholders, and holders of other contractual rights against the government, have to start worrying about the prospects for outright default or default through inflation. These are possibilities in our future, just as in the future of Greece.

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Judge Posner presents a very precise and careful analysis of what it means for a nation to go broke.

I would offer a much shorter, less precise, answer to the question.

You know you are broke as a nation when the amount you must borrow (as a percentage of GDP) to cover the difference between this year's outlays and this year's revenues is more than three times the long-term growth of the economy, and you have no credible plan to reduce this discrepancy at any reasonably foreseeable point in the future. This comes under the heading of trying to fool all of the people all of the time, which is not a good plan, even in the bond market.

Secondly, you know you are broke as a nation when the present value of all future existing revenue streams does not begin to cover the present value of all future liabilities (whether those liabilities be legal contracts or "mere" promises like Social Security and Medicare). Obviously, the size of that gap depends upon discount rates and assumptions about economic growth, which are always controversial. But no responsible person who has looked at this problem finds the gap less than staggering or the politcal measures required to close it less than drastic.

So when the only remedies that will save us from outright default, or default through inflation, are themselves problematic, I conclude that, yes, we are broke. Now.

What would happen if the government just "printed" the money to pay all its debts and mailed every citizen a check for like $100,000? Seems to me this would stimulate the economy, people would have their 100,000 to insulate them a bit from the resulting inflation, which would sorta force deleveraging by making peoples mortgages and debts and entitlements be in smaller dollars. Peeps could pay off their debts and buy stuff again so demand would go up, and when demand goes up the labor market should tighten and we might see some less pathetic wage growth. Big losers would be Treasury and debt holders, but if you have an idea that doesn't do at least that amount of damage I'd like to hear it... Obviously in the future the government should be less incompetent and replace the tax code with a carbon tax and such but that's kinda a different issue.

Therefore, the asset of a nation boils down to the willingness of its citizens to work for someone else, someone unknown, as opposed to working for themselves and their families. Let’s be honest with ourselves, let’s look inside, and let’s be realistic. How much of that asset do we really posses?

So to rephrase it in more substantive terms I would say:

“The major asset of any government is its ability to exercise its taxing power, while at the same time convincing people to keep working ever more for someone else, someone unknown, as opposed to working for themselves and their families.”

Applying the notion of solvency to the federal government, as if it were some giant corporation, is really is what philosophers would call a category mistake. The federal government is not a corporation and has no significant assets in any meaningful sense which can be balanced against its liabilities to make an assessment of solvency or determine whether or not it is "broke." Such talk is economic nonsense and political babble masquerading as science.

Does this mean there is no need to worry about the obligations the federal government has? Of course, not. But the incredibly low interest rates on treasuries tells me the time to worry is not now. Get back to me when interest rates start climbing.

Intuitively, the US government is broke and most of the public believes that except for the part of the public which does not know from where government assets are derived. And from a practical point of view, the consequences of what Posner decribes as government incompetence (I agree)is lack of confidence, lowering standard of living and social disintegration. Not to mention inability to execute foreign policy. One consequence of any remedial choices considered will be everyone being equally poor. Finally the equalitarians will have what they want. Even worse, because of their inability to monetize debt, the cities, counties and towns are broke (insolvent) and looking to the federal government to bail them out.
Worse yet, all of this can be laid at the feet of self serving political vote and power seeking and an uninformed voting public. Historically, the situation is mindful of Rome and the Ancien Regime
of Louis XVI. But then again, no one seems to learn from history.

I suspect a long and deep spell of deflation in monetized U.S. asset values will only make those assets more attractive for acquisition by foreigners and boost the appetite for asset fire sales by Americans who wish to preserve some position on the authoritative scale of wealth or the perception of access to wealth - i.e., to be a player. The crowd will predictably gravitate toward the proverbial lowest common denominator. It's the same behavior we see with the creditors Judge Posner talks about - the race to prime an insolvent debtor's assets ahead of other claimants - except this time we're the struggling debtor.

I wouldn't go so far as to say the US is broke and bankrupt, however I would not consider the US government (or most national governments for that matter) to be an investment grade credit. The US had an opportunity to roll back the big government tax, spend & borrow culture in 2001. Unfortunately Bush used 9/11 as an excuse to feed his urge to spend money.
I would consider the US to be a "special situation investment" in need of serious restructuring. I truly believe that most people in America are in favor of spending cuts by the government. However the advocates for bigger government are more organized & motitvated to preserve the status quo.
I have a number of ideas to cut spending to reduce deficits. However neither party has interest in cutting spending. Whether its the tax fattened hyenas of the Democrat party or its the wimpy weak willed go along to get along Republicans the politicians crave spending taxpayer money. It will take Americans putting down the channel changer and pressuring their elected officials to do the people's business instead of the lobbyists business.

A federal workout is already underway. There are some reasons to be optimistic. New communications technology had not filtered into the public sector until the Obama administration, and there could be large cost-savings over the long haul in traditionally expensive government functions, such as recordkeeping and reporting.

But the risk of a default is not outside the pale for some states, such as California. The main difference between California and Greece is that Germany decided to bail Greece out whereas it's not clear that there would be political support for our federal government to do the same.

If Italy looks surprisingly good, that's because, unlike other Western countries that we would sooner associate with "good governance", it hasn't borrowed unholy amounts of money in this crisis to finance a stimulus package. Thus the Italian government comes out of this looking quite respectable, its indisputable incompetence and corruption notwithstanding. Some would say, though, that Italy's piggybacking on other nations' stimulus efforts is yet another example of its corruption...

As flakey as this sounds (i'm something of a Darwinian though spent 2.5 years living in Zen and Thera Buddhist monasteries as well as a Benedictine monastery..Dad lives 9 miles from Down House too !) do either of the Gents have any time for the place when the brain is absent of thought, still etc ?
Thanks a lot

Deficits are not a problem. They can be simply wiped out through international cooperation.

If governments worldwide simply start taking a lot of money from highly productive people, wealthy savers and investors and then distribute it to average people then …

You simply have the curious phenomenon whereby all of humanity all of a sudden starts being able to afford and enjoy a lot more goods and services without humanity actually having to produce more goods and services. Voila! The perpetual machine of prosperity! If we could only believe in “hope and change” it would actually be possible…

I feel sometimes we can overthink the real basic fundamentals of why a country can end up in financial trouble.

It is easy to lose sight of what a government actually is. The government is a representative of the people. Tax is our individual contribution to the collective "kitty" that the government is to then use to provide goods and services to society.

Therefore in the long run we only ever have two options, either a) be taxed more OR b) expect to be given less.

It sometimes seems to me that those that complain the most about tax are the same people that expect the most from the government, and often contribute less.

Perhaps you might think this is a simplistic view, but I believe in simple truths.

"Broke" is a slang term for insolvency, the condition of having reached the limits of one's available resources and while still being unable to meet all of one's debt obligations. Because states, unlike individuals and corporations, can increase taxes and print money, it is far more difficult to tell when a state has reached the limits of its resources. Difficult, but not impossible. The concept of insolvency would be a "category mistake" as applied to states only if states never do in fact default. But of course they have and they do.

At the moment, the bond market is happy to lend us all the money we need at very low rates of interest, apparently confident of our ability to do whatever is required to remain solvent. I certainly hope that confidence is justified, but I am dubious. Many remedies that might actually work are simply not feasible politically. No doubt that is why public officials are always ready to call for another commision to study the problem, but never seem willing to actually do anything about it.

This is a very good post because it recognises that the answers to the fiscal question will need to be found on both sides of the tax and spend equation and not on one side alone.

The U.S. government has far more economic capacity than Italty and Spain and ought to be at far less risk of default. Its biggest risk lies in the hollowing out of the political centre leading to political paralysis as sensible compromise is characterised (bastardised) as betrayal or worse.

This leads to the result that nothing substantial can be done to remedy the problem until the edge of crisis is reached and the US is close to default

I will start by stating that I have a lot of respect for both Becker and Posner. I must, however, be critical of the fact that Judge Posner implicitly assumes that all of the tangible assets of both the federal government and state and local governments have a value of zero. This is certainly not the case, as can be seen by the privatization efforts of states and cities regarding shipping docks, airports, toll roads, etc. I cannot even guess at the total value of such assets as government buildings, hospitals, military facilities (that can and have been converted to private sector uses), etc. One flaw in our federal budgeting is that capital expenditures and operating expenditures are all treated the same--as if they are all current costs for which there are no future benefits. In fact, the future benefits of a capital good or building purchased by a governmental entity to society are much different from a payment to a private citizen on Social Security (the future benefits of which are likely to be close to, if not equal to zero).

Like private corporations, governmental entities are able to "leverage" their equity through debt. Like Judge Posner, I do fear that we are attempting to over-leverage whatever governmental or public equity we have. I also doubt that the market for federal debt is so irrational and/or inefficient that the Treasury can continue to issue mountains of debt at low interest rates unless investors recognize the the federal government is not insolvent.

There is real equity in the form of tangible government assets that should also be shown on the balance sheets of American governmental entities, and this may be a reason why the federal government can continue to issue huge amounts of debt at low interest rates. And, like the case of Freddie Mac and Fannie Mae, state and local governments may be able to continue to issue large amounts of debt because investors in municipal securities believe that there is an implicit federal guarantee should any large state (i. e., California) be unable to find buyers for its new debt issuance.

Whether it's the prospect of default, or whether it's a matter of what has to happen to incentives to produce in order to avoid default (taxes), the prospects are quite dismal.
America will have to descend to incentives to produce similar to what existed in the '70s except that in 2010 she will be doing so in a world where other, once basket-case nations, finally have incentives to produce, and thus compete with Americans. So Good luck!

How would all this relate to Hauser's Law "that, in the United States, federal tax revenues since World War II have always been equal to approximately 19.5% of GDP, regardless of wide fluctuations in the top marginal tax rate?"

It would seem that the federal government's "power to tax" is more or less an asset with a fixed value relative to GDP and that it's real asset is the ability to promote long term economic growth through low taxes, stable prices and a regulatory environment that is as simple as possible and gives both consumers and businesses a level playing field.

Richard Posner, the usual sophistry. First, the dollar is backed by NOTHING. All government debt is denominated in dollars which can be produced at nominal expense. Deflation should therefore not be possible if the government is receptive to proper maintenance of adequate dollars in the hands of those who create demand for goods and services. Monetizing the debt will occur in any event. Who now benefits from this "economy"? The Jewish bankers and Federal Reserve banks who control the "money supply". Recently the Fed has been purchasing treasury debt in large quantities. This is a no lose proposition since the money which the government could create at nominal cost is instead "borrowed" from the Fed which also creates the "money" at nominal cost. Can the banker in Monopoly go broke when he controls the supply of money? The government is not a private entity and the analysis by Richard Posner is JUST PLAIN STUPID. The poster who suggested the current economic problems could be resolved by simply issuing checks in "dollars" to citizens has a rational working brain. The payments could be taxable which would immediately recover a portion of the funds and result in some progressivity. Citizens could then vote (supply and demand) on how to spend the money rather than have political considerations dictate. If we have a TRILLION dollars to fight surrogate wars for Israel (and give that criminal religious enclave as much as eight billion dollars a year), we must be extremely wealthy.